Your 401(k) account is one of the best ways to benchmark funds for your retirement. While a traditional account will allow you to invest in mutual funds, bonds and stocks – a self-directed, or solo 401(k), offers you many more investment opportunities. With a solo 401(k), you can invest in virtually anything, including real estate precious metals, private placements, and even renewable energy sources! Better yet – unlike a self-directed individual retirement account (SDIRA), you can do all of this without having to go through a custodian, which can save you both time and money. However, as with anything governed by the Internal Revenue Service (IRS), there are certain types of transactions that are prohibited. Understanding these regulations can help keep your account from being penalized and fined. Let us take a look.
The Disqualified Person
Before we talk about prohibited transactions, it is important for you to understand what a “disqualified person” is. The IRS typically defines a disqualified person as the account owner (you) and certain family members. Additionally, entities that are directly (or indirectly) connected to your solo 401(k) account, such as an LLC that is under 50% (or more) control by you or one of the forbidden family members. Not all family members are included in this however. Ancestors, including your father, mother and grandparents, and your direct lineal descendants, like your spouse, children and grandchildren, are disqualified persons. Indirect descendants and non-relatives, however, are not prohibited. This includes friends, siblings, uncles, nieces, cousins, and stepchildren.
The IRS prohibits any transaction that benefits you personally or one of the disqualified persons. In the simplest terms, a prohibited transaction is one that occurs between your solo 401(k) and a disqualified person. In fact, the IRS specifically prohibits the following transactions.
- The sale, lease, or exchange of real estate between a disqualified person and your solo 401(k). An example of this type of prohibited transaction would be selling, or leasing, a property owned by your solo 401(k) to your mother. You would also be prohibited from using funds from your solo 401(k) account to invest in your son’s limited liability company (LLC). Additionally, you could not use your personal finances to pay for expenses that are related to your solo 401(k), such as hiring a plumber to fix your rental property owned by your account.
- The extension of credit of lending of money between your solo 401(k) and a disqualified person. For example, you cannot acquire a personal credit card through your solo 401(k). You also cannot use assets from your solo 401(k) as a deposit or for collateral related to a personal loan. If your spouse is not a member of your solo 401(k) (which is prohibited!), you cannot loan them money from that account.
- Goods, services, or facilities that are furnished between your solo 401(k) and a disqualified person. This means you cannot hire your daughter to manage your rental property owned by your solo 401(k) account. You also cannot hire your father to perform maintenance work on that rental property.
- The transfer of income or assets from your solo 401(k) to a disqualified person. If you take funds from your solo 401(k), without reporting it as a loan, to pay for your personal debt, the IRS considers this a prohibited transaction. You also cannot receive a salary for managing your solo 401(k)’s real estate properties. Depositing money into your personal account from your solo 401(k) is not permitted either. Not can you use funds from your solo 401(k) for a loan to an entity you have 50% or more ownership of.
- You cannot personally earn income or receive assets from your solo 401(k) account. For example, you cannot earn a commission as a real estate agent for selling a property to your solo 401(k) account. You also cannot use your solo 401(k) account to invest in your mother’s business, nor can you use your account to lend money to a business you partially control or manage.
- You cannot use income or assets from your solo 401(k) plan to receive consideration in connection with a transaction. Trying to secure a promotion through a loan provided by your solo 401(k) to a company you work for is prohibited under this regulation.
The IRS enacts these regulations to ensure the appropriate taxes are paid to them and the U.S. Department of Treasury. Depending on if you made contributions to your account with pre-tax dollars or post-tax dollars will dictate when and how much you pay on your investments. For contributions that are made pre-taxes, your account’s funds are in a tax-deferred state. This means you pay taxes only on your distributions. Because a solo 401(k) is a retirement account, if you take a distribution before the age of 59 ½, it is considered an early distribution and it will be subjected to penalties and fines. As long as you pay these taxes, however, the IRS permits it.
The Easy Way to Figure out if a Transaction is Prohibited
IRS regulations can be confusing. Royal Legal Solutions is no stranger to IRS regulations! We can help explain any concerns you may have. For the most part, when you are going to initiate a transaction through your solo 401(k), ask yourself if any of the disqualified persons named by the IRS will profit from it. If so, the transaction is likely prohibited.
While you can invest in almost anything with a solo 401(k), there are two exceptions. You cannot invest in collectibles, such as artwork, rugs, stamps, and certain types of coins. (Note, however, that you can invest in gold, silver, platinum, and palladium coins that are 99.5% or more pure.) Additionally, because a solo 401(k) is considered by the IRS to be a trust, you cannot invest in S corporation stocks.
Royal Legal Solutions Can Help
While you do not need a custodian with a solo 401(k), Royal Legal Solutions can still help. Our expert staff can assist you with opening a new solo 401(k) account, as well as providing support for transferring your contributions from a previous account and simplifying the overall process.